The Fed and the Price of Oil

January 15, 2015

Given the potential for financial losses triggered by oil's price collapse to cascade into the financial sector at large, the Fed may well be forced to intervene either directly or indirectly.

An email dialog with correspondent Mark G. last month alerted me to the key role the Federal Reserve plays in the price of oil-- either helping to maintain the current low prices (by enabling financing of new production) or pushing down supply and production (by making financing of new production more difficult).

Capital--cash or credit--is as important as the actual hydrocarbons in producing fuels and natural gas. Without fresh capital or financing, the oil/gas will remain in the ground.

The Fed flooded the global economy with credit borrowed in U.S. dollars during its quantitative easing programs. Need to borrow billions of dollars to finance new oil production? No problem when the Fed was emitting trillions of dollars into the global financial system.

Now that the Fed has ended its QE money-printing program, the dollars have dried up. The other source of dollars--U.S. trade deficit--has also contracted as the trade deficit has declined.

This decline in the availability of U.S. dollars has placed global borrowers with dollar-denominated debt in a vice as the scarcity of dollars meets the pressing need to refinance debt that's coming due and needs to be rolled over.

Strong demand and reduced supply lead to much higher prices for dollars--which is exactly what the world is seeing.

Domestic oil producers have a source for financing: the Fed. As I have speculated before, the Fed may not be a passive observer of the domestic oil patch's financial travails. Given the potential for financial losses triggered by oil's price collapse to cascade into the financial sector at large, the Fed may well be forced to intervene either indirectly through proxies or directly.

As I explained in Will the Fed Intervene in the Oil Market? (December 23, 2014), the Fed has a variety of intervention options, from buying oil futures contracts to buying at-risk oil-based bonds to enabling proxies to roll over oil-based debt.

Compare the staggering cost to oil exporters in lost income to the modest cost of the Fed financing domestic oil-based debt. If the domestic oil industry needs $100 billion in debt to be buried in a balance sheet somewhere or rolled over, the Fed can arrange this size of financing without raising an eyebrow. Compared to a balance sheet of $4+ trillion and the Fed's essentially unlimited credit spigot, what's $100 billion more in aid to the domestic oil/gas industry?

The oil exporters who are losing tens of billions of dollars in cumulative revenue do not have any equivalent Sugar Daddy. Their declines in income will have to be matched by declines in spending, declines that will cascade through the oil exporters' economies with devastating impact.

If you want to deploy the oil weapon, make sure you have a central bank that can intervene at will, in whatever size is necessary, to reduce the impact on your own economy, while maximizing the financial pain inflicted on the targets of the oil weapon.

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